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Iraq Could Make Or Break The OPEC Deal

The markets are betting that the OPEC extension is all but guaranteed after Saudi Arabia and Russia announced their intention to support a nine-month extension. Saudi energy minister Khalid al-Falih tried to put to rest any possibility of dissention. “We think we have everybody on board,” al-Falih said on Bloomberg TV. “Everybody I’ve talked to indicated that nine months was a wise decision.”

Rumors have surfaced that OPEC might even be considering deeper cuts, perhaps on the order of 2.5 million barrels per day (mb/d), which is twice as much as the current reductions. Because inventories have declined slowly, there is a greater recognition that more aggressive action might be needed to bring the oil market back into balance.

But even as oil bulls – and U.S. shale drillers, no doubt – salivate at the possibility of steeper cuts from OPEC, there is at least one country that could derail those efforts: Iraq. OPEC’s second largest producer was one of the last holdouts in the lead up to the original six-month deal. Iraqi officials hesitated at cooperating with OPEC to reduce output because it argued that its multi-year war with the Islamic State should exempt it from any production limits, just as security problems in Nigeria and Libya were cited as justification for allowing an exemption for those two countries.

Even though were able to move past those disagreements, Iraq became a straggler when it came time for implementation. In the first quarter, Iraq produced 80,000 bpd more than the agreed upon production limit of 4.351, according to Reuters. As of April, Iraq was still above its cap by some 20,000 bpd, based on OPEC’s secondary sources data. Moreover, because the agreement is a six-month average, even if Iraq brought its output down to the target level for May and June, that would not mean it will have achieved compliance – Iraq would have to cut significantly below that level in order to bring its six-month average down sufficiently. So, it is safe to say Iraq will not meet its commitment.

But that issue is rather minor compared to the task at hand for al-Falih in trying to keep Iraq on board going forward. The reason is that Iraq has new production capacity set to come online in the third and fourth quarter of 2017. The bulk of Iraq’s production comes from its southern oil fields in and around Basra, where several major international companies operate, including BP, Royal Dutch Shell, ExxonMobil, Lukoil and CNPC. Production from these southern oil fields could actually increase as companies' complete maintenance and bring some new projects online. "We achieved this great achievement of 4 million barrels per day ... middle of 2016, and now we have climbed up and we are reaching about 5 million barrels per day beginning of second half of this year," Iraq’s oil minister Jabbar Al-Luaibi said in March at the CERAWeek Conference in Houston.

“Leaving that productive capacity idle will come with an opportunity cost that Iraq may prove reluctant to bear,” Harry Tchilinguirian, head of commodity-markets strategy at BNP Paribas SA, told Bloomberg.

But that does not mean that Iraq will comply. So far it has fallen short of 100 percent compliance, a fact that Saudi Arabia is willing to overlook in order to keep the deal from falling apart. Indeed, Saudi Arabia has made up for Iraq’s foot-dragging, cutting deeper than required. “This is OPEC’s problem: There is no punishment mechanism,” independent oil analyst Anas Alhajji told Bloomberg. “A deal is one thing, implementation is another.” Recent data shows that even as Iraq appears ready to sign on to a nine-month extension, its exports are on the verge of setting a record for the month of May.

Moreover, the Iraqi oil minister has long felt that it received the short end of the stick form the original agreement in November. Fellow OPEC members Nigeria and Libya were given exemptions and Iran was allowed to increase production. Iraq, meanwhile, was forced to make the second largest cut. This, plus the oil minister’s past comments about ramping up production this year, should make oil watchers skeptical about Iraq’s willingness to keep production in line with the agreement for the next nine months.